The UK trade deficit - does it matter?

Back in the 1980s people obsessed over the UK’s trade deficit, but now it barely warrants a mention. Eoin Gleeson asks if they are right to be this sanguine.

What is a trade deficit?

A trade deficit occurs when a country is importing more goods than it exports. It reflects the fact that a country is living beyond its means spending more on foreign imports than it makes from selling its own exports abroad. To give an idea of the scale of a trade deficit, the figure is typically compared to the country's Gross Domestic Product (GDP) the total value of goods and services produced in a country in a year. Britain's trade deficit was £60bn in 2006, or 5% of GDP.

Does this matter?

In principle, there is nothing wrong with a trade deficit. It simply means that a country must rely on foreign direct investment or borrow money to make up the difference. This is the argument that is often used to justify the massive $800bn deficit that the US has built up in recent years as long as China keeps covering the cost of the deficit by buying US Treasury bonds (effectively lending money to the US), the size of the deficit does not matter. However, a large deficit can put serious pressure on a country's currency; according to investment guru John Mauldin, no country has "ever run a deficit of more than 5% without at least a 30% drop in the value of its currency". This is simply due to the fact that the more that imports outweigh exports, the greater the demand for foreign currency over the domestic one. Recovering from a large trade deficit or collapsed currency is a painful experience for a country. The recession in Britain in the early 1990s was largely due to huge deficits built up in the 1980s.

So why are we running a big deficit now?

The swing towards a trade deficit in the UK partly reflects the fact that the British manufacturing sector is in terminal decline. Britain only really has a foothold in two manufacturing sectors: pharmaceuticals and arms. UK plc now specialises in financial services, advertising, public relations, design and management consultancy. Or, as Larry Elliott and Dan Atkinson put it in their book Fantasy Island, "we count the money and we do the bullshit". It also reflects the fact that UK consumers have been spending massively on imported goods a boom fuelled largely by borrowing against soaring house prices.

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So should we be worried?

Some argue that trade deficits don't matter in a globalised economy. A prime proponent of this view is economist Anatole Kaletsky, who claims in The Times that the key to business success these days is to control the design and marketing stages of developing a product, because the task of producing goods can be shipped out to subcontractors in developing countries. This has resulted in what Kaletsky calls the "platform company" businesses such as Dell, Nokia and Apple that "sell everywhere, but produce nowhere". As manufacturing is "the most volatile and capital-intensive part of the business process", outsourcing it means Western economies have also outsourced economic volatility, making "high levels of borrowing both safer and more attractive for business and consumers in the advanced economies". In other words, a deficit is actually a sign of strength in today's world and a surplus shows a country stuck in the past.

How does this apply to the UK?

As Elliott and Atkinson put it, the New Labour view is that the UK is now a "knowledge economy" in a better position to exploit the "sunrise industries of the 21st century" biotechnology, robotics and pharmaceuticals. "Successful economies will need brain rather than brawn." But the fact of the matter is that the knowledge economy will not be enough to balance our finances. Even if you include services the UK exported last year, the trade deficit only falls from 5% to around 4.2% of GDP for 2006. And some argue that this "knowledge economy" is unsustainable without a strong manufacturing sector. "It is not possible to sustain world-class education or research without world-class manufacturing," says Ivor Tiefenbrun, founder of Linn Products, claiming that manufacturing typically drives around three-quarters of all research and development in an economy.

So why has the economy done so well in recent years?

Massive spending by the Government and consumers, fuelled by low interest rates and surging house prices, has enabled the UK to live beyond its means, suggest Elliott and Atkinson. This happy situation has been enabled by cheap imports from developing countries and the willingness of foreign lenders to hold our debt. But the more the trade deficit expands, the more we owe to our foreign lenders and the greater the pressure on future generations to repay our debts. With interest rates rising to tackle inflation, the property bubble could burst, sending us into recession. If the economy goes down, that will put pressure on the pound, which in turn would push up inflation, preventing the Bank of England from cutting rates to ease the squeeze on indebted consumers. That's when we may find that trade deficits do matter after all.

Just what are we doing in Bullshit Britain'?

The people of Bullshit Britain', as Elliott and Atkinson call it, are overeducated and underemployed. Essex University's Institute for Social and Economic Research found in 2002 that a third of men and 41% of women were overqualified for their jobs. Despite Government rhetoric, employment growth in recent years has mostly been at the low-skill end of the services sector. The chunk of the population in domestic service is "as high as it was in the 1860s", while the fastest-growing occupation between 1992 and 1999 was hairdressing.

Eoin came to Money Week in 2006 having graduated with a MLitt in economics from Trinity College, Dublin. He taught economic history for two years at Trinity, while researching a thesis on how herd behaviour destroys financial markets.

Eoin acts as managing editor of MoneyWeek's newsletters.